Where Are We Now?

With 2013 less than a month away, let's review where we're at in 2012 thus far. It's become clear that the game of printing money at the Federal Reserve (i.e. quantitative easing) isn't working the way many had hoped it would. The S&P 500 is up 13.5% on a year-to-date basis but has yet to reclaim the levels seen since the Bernanke Top (September 14). Gold continues to remain inflated courtesy of the Fed having also declined in price since September. Brent crude oil is down significantly since its February highs and we expect it to head lower into the new year. 2013 will largely be affected by the outcome of the fiscal cliff. Should Congress get its act together, we can, at least for the short-term, expect a buyer's rally across multiple asset classes.

The US business reported +2.5% same-store sales growth, far in excess of -0.8% consensus. The US division was benefiting from a calendar shift and a heavy value push. On a two-year average basis, trends improved to +4.5% from 1.5%. October was negatively impacted by calendar shifts; the chart below, on the right, shows calendar adjusted trends which illustrate a more modest improvement in November from the previous month’s trend.

November was driven by a heavy focus on the Dollar Menu. Looking forward, the McRib makes its comeback on December 17th (pushed back from original relaunch date in late October) but 4Q12 trends are still facing an uphill battle as MCD faces its toughest compares of the year in December. Heading into 1Q13, compares will remain very difficult and the competition will also be heating up with Taco Bell ramping up its national voice.

Europe

MCD Europe reported 1.4% comps in November, beating +0.1% consensus. The calendar shift impact helped business in Europe with many previously-negative markets turning positive in November. The UK continued to see positive organic growth in its business. Germany, one of the most important markets in Europe, continues to act as a drag on overall results. Margins in Europe are tracking lower-than-planned this quarter as promoting value has taken a toll.

APMEA

The APMEA business grew same-store sales +0.6%, led by Australia, despite ongoing weakness in Japan. A significant portion of the headline improvement in two-year average trends in APMEA was due to the calendar shift. The value message continues to resonate in Australia but trends in China continue to decelerate with trends roughly flat in November.

Takeaway

November was a decent month for McDonald’s but, combining October and November to smooth out calendar-shift impacts shows a trend roughly level with September. We believe that the business, on a global basis, did improve sequentially but by much less than the headline numbers might suggest. The true improvement was modest, in our view, and we would need to see several months of improvement for our skepticism to reverse. We continue to expect margin pressure in 2013 and view FY13 consensus EPS estimates of $5.80 as overly bullish. Until expectations come in, we are not advising clients to buy this stock.

Howard Penney

Managing Director

Rory Green

Senior Analyst

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12/10/12 01:06 PM EST

DRI - The dividend has become a liability

This note was originally published December 08, 2012 at 08:51
in Restaurants

The recent DRI press release stating the latest disappointment stopped short of dealing with reality.

A recent note we published highlighted the DRI Annual Report as an important document for investors given the primary takeaway which was: the growth ethos at Darden is an entrenched as ever. Against a backdrop of sustained traffic declines, it is jarring to read the following sentence: “Our brands have strong individual and collective growth profiles”. We believe that management has, and is continuing to, set itself up to miss expectations.

Unfortunately, the press release of December 4th did not address the most important issue that the company is facing: excessive growth.

Clearly, in light of the fundamentals at the company’s largest brands, the five-year growth plan outlined in the Annual Report needs to be reevaluated. The thesis of our Darden Black Book this past summer expressed our conviction that Darden’s continuing acceleration of new unit growth over the past couple of years has masked evidence of secular decline in Olive Garden and Red Lobster. Knowing what we now know about how FY13 to-date only adds to the need for management to address how its pace of growth can be sustained without further erosion to the financial health of the company.

The message from Darden’s management team highlights the economy as the biggest issue facing the company and, furthermore, sees weakness in trends at its core brands as being transitory in nature. We have suggested that the longer-term view, as defined by the data, suggests an altogether different story.

The traffic trends at Olive Garden and Red Lobster clearly are demanding significant action of management. The economy is undoubtedly a factor but the poor performance of the “Big Two” versus the Knapp Track casual dining benchmark is a clear indication that the company’s sluggish traffic trends are not entirely attributable to the macroeconomic environment. The data points – traffic trends – that we are pointing to as a primary reference for our thesis are indicative of, in no small part, self-inflicted wounds.

If the company has become dependent on growth as a drug for all ailments, management’s message is not indicating that Darden is facing up to its growth problem. Stating that the “core brands remain highly relevant to restaurant consumers” can be supported by pointing to the average unit volumes at Red Lobster and Olive Garden as being some of the strongest in the industry. We believe this statement to be misguided, however, when considering same-restaurant sales trends – a far more relevant metric when assessing relevance to the consumer.

Going back to the very first conference call announcing Clarence Otis as CEO of the company, the pervading theme throughout his tenure has been “growth”. Acquisitions of LongHorn Steakhouse and, more recently, Yard House, are testament to the unwavering loyalty Darden’s CEO has to his philosophy.

Now the numbers don’t add up. The balance sheet is levered up and margins are declining. The company is not generating enough cash to pay the dividend given the current rate of capex growth. The dividend has become a liability.

Will management admit its past mistakes or, at least, change course and slow growth? Or will reality continue to be ignored? The earnings call on December 20th will be the first chance for management to face the music. The sooner they do it, in our view, the better.

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12/10/12 10:01 AM EST

Temps and Gas

The AECO spot gas price is trading at a $0.06/MMBtu premium to the Henry Hub spot (in USD). The NYMEX curve has slid since mid-November on a warmer-than-expected start to the 2012/13 winter in the US northeast, but AECO has held firm above $3.25/MMBtu (USD) on cold weather in Western Canada and a swifter fall in supply.

What’s interesting is that weather forecasts currently expect warmer-than-normal temps in the southern US for Jan/Feb/March. Conversely, forecasts call for normal temps on the east coast and a colder-than-normal winter in western Canada for the same time period. As such, expect the differential to remain tight; the $0.06 premium compares to the 2007-2011 average differential for the time-step of a $0.37/MMBtu discount.

CASUAL DINING UPDATE

Industry data is indicating that casual dining restaurant companies saw a sequential uptick in trends in November from October.

Knapp Track

Casual Dining comparable restaurant sales growth for November 2012 was +0.7% versus -0.9% in October and +0.6% in November 2011. This is a sequentially better number; the two-year average trend improved by 75 bps month-over-month.

Casual Dining comparable restaurant guest counts growth for November 2012 was -0.9% versus -2.8% in October and -1.6% in November 2011. The sequential change, in terms of the two-year average trend, was +55 bps.

This number is also sequentially better but, for the broader industry, negative traffic growth is still a concern given the ever-increasing level of discounting casual dining operators are implementing in their restaurants.

We remain bearish on DRI and BWLD. Our favorite name, on a relative basis, in casual dining is EAT.

Takeaway

We believe that consensus likely remains too bullish on casual dining trends in FY13, given the 2-3% comps that are being projected for the industry, on average, for 1H13.

The Restaurant Value Spread could be at the beginning of a bottoming process, as the first chart below suggests, but we will be looking to gain more conviction on that when the BLS releases November CPI data on the 14th of December. If the slope of the line representing the spread does begin to reverse, it would be a marginal positive for casual dining traffic.

Howard Penney

Managing Director

Rory Green

Senior Analyst

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12/10/12 09:58 AM EST

Deflating Commodity Bubbles

One of our big macro themes for back half of 2012 and into 2013 is that the super commodity bubble that’s occurred due to the Federal Reserve’s inflation-inducing policies will deflate. Sure enough, if you look at the chart we offer up below, you can see that the cycle is moving and that commodities are deflating after a massive run in 2010 and 2011. For the record, the CRB Index is down -17.7% since the start of 2Q11 and down another -4.3% quarter-to-date. Interestingly, deflation could act as an economic stimulus of sorts through disinflation in actual consumer and producer prices.

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